Pricing Decisions and Cost Management

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Pricing and Business

How companies price a product or service ultimately depends on the demand and supply for it Three influences on demand & supply:
Customers 2. Competitors 3. Costs
1.

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Influences on Demand & Supply

1.

2.

3.

Customers influence price through their effect on the demand for a product or service, based on factors such as quality and product features Competitors influence price through their pricing schemes, product features, and production volume Costs influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply)
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Time Horizons and Pricing

Short-run pricing decisions have a time horizon of

less than one year and include decisions such as:

Pricing a one-time-only special order with no long-run

implications Adjusting product mix and output volume in a competitive market

Long-run pricing decisions have a time horizon of

one year or longer and include decisions such as:

Pricing a product in a major market where there is some

leeway in setting price

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Differences Affecting Pricing: Long Run vs. Short Run

1.

2.

Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment prices are decreased when demand is weak and increased when demand is strong
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Alternative Long-Run Pricing Approaches

Market-Based: price charged is based on what

customers want and how competitors react Cost-Based: price charged is based on what it cost to produce, coupled with the ability to recoup the costs and still achieve a required rate of return

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ABC Manufacturing Cost Illustration

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Product Profitability Using ABC Costing: Illustration

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Markets and Pricing

Competitive Markets - use the market-based approach Less-Competitive Markets can use either the market-

based or cost-based approach Non-Competitive Markets use cost-based approaches

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Market-Based Approach
Starts with a target price Target Price estimated price for a product or service

that potential customers will pay Estimated on customers perceived value for a product or service and how competitors will price competing products or services

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Understanding the Market Environment

Understanding customers and competitors is important because:

Competition from lower cost producers has meant that prices cannot be increased 2. Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes 3. Customers have become more knowledgeable and demand quality products at reasonable prices
1.
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Five Steps in Developing Target Prices and Target Costs

1. 2. 3.

Develop a product that satisfies the needs of potential customers Choose a target price Derive a target cost per unit:
Target Price per unit minus Target Operating Income per unit

4.
5.

Perform cost analysis Perform value engineering to achieve target cost

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Value Engineering
Value Engineering is a systematic evaluation of all

aspects of the value-chain, with the objective of reducing costs while improving quality and satisfying customer needs Managers must distinguish value-added activities and costs from non-value-added activities and costs

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Value Engineering Terminology

Value-Added Costs a cost that, if eliminated,

would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or service Non-Value-Added Costs a cost that, if eliminated, would not reduce the actual or perceived value or utility customers obtain from using the product or service. It is a cost the customer is unwilling to pay for
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Value Engineering Terminology

Cost Incurrence describes when a resource is

consumed (or benefit foregone) to meet a specific objective Locked-in Costs (Designed-in Costs) are costs that have not yet been incurred but, based on decisions that have already been made, will be incurred in the future
Are a key to managing costs well

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Cost Incurrence and Locked-In Costs Graph

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Problems with Value Engineering and Target Costing

Employees may feel frustrated if they fail to attain targets 2. A cross-functional team may add too many feature just to accommodate the wishes of team members 3. A product may be in development for along time as alternative designs are repeatedly evaluated 4. Organizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the firms value chain
1.

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Target Costing Illustration

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Target Costing Illustration, Continued

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Cost-Based (Cost-Plus) Pricing

The general formula adds a markup component to the

cost base to determine a prospective selling price Usually only a starting point in the price-setting process Markup is somewhat flexible, based partially on customers and competitors

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Forms of Cost-Plus Pricing

Setting a Target Rate of Return on Investment: the

Target Annual Operating Return that an organization aims to achieve, divided by Invested Capital Selecting different cost bases for the cost-plus calculation:
Variable Manufacturing Cost Variable Cost Manufacturing Cost Full Cost
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Common Business Practice

Most firms use full cost for their cost-based pricing

decisions, because:
Allows for full recovery of all costs of the product Allows for price stability It is a simple approach

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Life-Cycle Product Budgeting and Costing

Product Life-Cycle spans the time from initial R&D on

a product to when customer service and support are no long offered on that product (orphaned) Life-Cycle Budgeting involves estimating the revenues and individual value-chain costs attributable to each product from its initial R&D to its final customer service and support Life-Cycle Costing tracks and accumulates individual value-chain costs attributable to each product from its initial R&D to its final customer service and support
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Important Considerations for Life-Cycle Budgeting

Nonproduction costs are large Development period for R&D and design is long and

costly Many costs are locked in at the R&D and design stages, even if R&D and design costs are themselves small

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Life Cycle Budgeting, Illustrated

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Other Important Considerations in Pricing Decisions

Price Discrimination the practice of charging

different customers different prices for the same product or service

Legal Implications

Peak-Load Pricing the practice of charging a higher

price for the same product or service when the demand for it approaches the physical limit of the capacity to product that product or service

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The Legal Dimension of Price Setting

Price Discrimination is illegal if the intent is to lessen

or prevent competition for customers Predatory Pricing deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices

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The Legal Dimension of Price Setting

Dumping a non-US firm sells a product in the US

at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the US Collusive Pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade
2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.